Reserve Bank of India Act, 1934

What are Forex Reserves?

Conceptually, a unique definition of forex reserves is not available as there have been divergence of views in terms of coverage of items, ownership of assets, liquidity aspects and need for a distinction between owned and non-owned reserves. Nevertheless, for policy and operational purposes, most countries have adopted the definition suggested by the International Monetary Fund which defines reserves as external assets that are readily available to and controlled by monetary authorities for direct financing of external payments imbalances, for indirectly regulating the magnitudes of such imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for other purposes. In India, the Reserve Bank of India Act 1934 contains the enabling provisions for the Reserve Bank to act as the custodian of foreign reserves, and manage reserves with defined objectives. The powers of being the custodian of foreign reserves is enshrined, in the first instance, in the preamble of the Act. The reserves refer to both foreign reserves in the form of gold assets in the Banking Department and foreign securities held by the Issue Department, and domestic reserves in the form of bank reserves. The composition of foreign reserves is indicated, a minimum reserve system is set out, and the instruments and securities in which the countrys reserves could be deployed are spelt out in the relevant Sections of the RBI Act.

Business which the Reserve Bank of India may transact:

1) The purchase and sale of gold or silver coins and gold and silver bullion and foreign exchange and the opening of a gold account with the principal currency authority of any foreign country or the Bank for International Settlements or any international or regional bank or financial institution formed by such principal currency authority or authorities or by the Government of any foreign country. 2) The purchase and sale of securities issued by the Government of any country outside India or by any institution or body corporate established outside India and expressed to be payable in a foreign currency or any international or composite currency unit,

being in the case of purchase by the Bank securities maturing within a period of ten years from the date of purchase

Issue Department:
The issue of bank notes shall be conducted by the RBI in an Issue Department which shall be separated and kept wholly distinct from the Banking Department, and the assets of the Issue Department shall not be subject to any liability other than the liabilities of the Issue Department. 1) The assets of the Issue Department shall consist of gold coin, gold bullion, foreign securities, rupee coin and rupee securities to such aggregate amount as is not less than the total of the liabilities of the Issue Department as hereinafter defined. 2) The aggregate value of the gold coin, gold bullion and foreign securities held as assets and the aggregate value of the gold coin and gold bullion so held shall not at any time be less than two hundred crores of rupees and one hundred and fifteen crores of rupees, respectively. 3) Gold coin and gold bullion shall be valued at a price not exceeding the international market price for the time being obtaining, rupee coin shall be valued at its face value, and securities shall be valued at rates not exceeding the market rates for the time being obtaining. 4) Of the gold coin and gold bullion held as assets, not less than seventeen-twentieths shall be held in India, and all gold coin and gold bullion held as assets shall be held in the custody of the RBI or its agencies. 5) The foreign securities which may be held as part of the assets shall be securities payable in the currency of any foreign country(repayable within ten years) which is a member of the International Monetary Fund.

Transactions in foreign exchange:

The Bank shall sell to or buy from any authorised person who makes a demand in that behalf at its office in Bombay, Calcutta, Delhi or Madras [or at such of its branches as the Central Government may, by order, determine], foreign exchange at such rates of exchange and on such conditions as the Central Government may from time to time by general or

special order determine, having regard so far as rates of exchange are concerned to its obligations to the International Monetary Fund.

Why Hold Forex Reserves?

Technically, it is possible to consider three motives i.e., transaction, speculative and precautionary motives for holding reserves. International trade gives rise to currency flows, which are assumed to be handled by private banks driven by the transaction motive. Similarly, speculative motive is left to individual or corporates. Central bank reserves, however, are characterised primarily as a last resort stock of foreign currency for unpredictable flows, which is consistent with precautionary motive for holding foreign assets. Precautionary motive for holding foreign currency, like the demand for money, can be positively related to wealth and the cost of covering unplanned deficit, and negatively related to the return from alternative assets. At a formal level, the objective of reserve management in India could be found in the RBI Act, where the relevant part of the preamble reads as to use the currency system to the countrys advantage and with a view to securing monetary stability. This statement may be interpreted to hold that monetary stability means internal as well as external stability; implying stable exchange rate as the overall objective of the reserve management policy. While internal stability implies that reserve management cannot be isolated from domestic macroeconomic stability and economic growth, the phrase to use the currency system to the countrys advantage implies that maximum gains for the country as a whole or economy in general could be derived in the process of reserve management, which not only provides for considerable flexibility to reserve management practice, but also warrants a very dynamic view of what the country needs and how best to meet the requirements. In other words, the financial return or trade off between financial costs and benefits of holding and maintaining reserves is not the only or the predominant objective in management of reserves.

Management of Forex Reserves in India

In India, legal provisions governing management of forex reserves are set out in the RBI Act and Foreign Exchange Management Act, 1999 and they also govern the open market operations for ensuring orderly conditions in the forex markets, the exercise of powers as a monetary authority and the custodian in regard to management of foreign exchange assets. The RBI Act stipulates the investment categories in which the Reserve Bank is permitted to deploy its reserves. The aid receipts on Government account also flow into reserves. The outflow arises mainly on account of sale of foreign currency to Authorised Dealers (i.e. for open market operations). There are occasions when forex is made available from reserves for identified users, as part of strategy of meeting lumpy demands on forex markets, particularly during periods of uncertainty. The net effect of purchases and sale of foreign currency is the most determining one for the level of forex reserves, and these include such sale or purchase in forward markets (which incidentally is very small in magnitude).

Source http://rbidocs.rbi.org.in/rdocs/Publications/PDFs/RBIA1934170510.pdf http://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/29869.pdf [RBI act]

[Special Lecture by

Dr.Y.V. Reddy, Deputy Governor, Reserve Bank of India, at National Council of Applied Economic Research, New Delhi on May 10, 2002]